Chapter 2Chapter 2Chapter 2Chapter 2Production Possibilities Production Possibilities and Opportunity Costsand Opportunity Costs

This chapter discusses This chapter discusses principles principles associatedassociated with with

This chapter discusses This chapter discusses principles principles associatedassociated with with

Division of Labor and SpecializationTechnological Change and Economic Growth

The Law of Increasing CostsOpportunity CostsProduction PossibilitiesFactors of Production

Absolute and Comparative Advantage

What are the Factors What are the Factors of Production?of Production?What are the Factors What are the Factors of Production?of Production?

Labor Capital Land Entrepreneurship

What is Labor?What is Labor?What is Labor?What is Labor?

The physical and intellectual effort of people engaged in producing goods and services

What is Capital?What is Capital?What is Capital?What is Capital?

Manufactured goods used to make and/or market other goods and services

What is Human Capital?What is Human Capital?What is Human Capital?What is Human Capital?

The knowledge and skills acquired by labor, principally through education and training

What is Land?What is Land?What is Land?What is Land?A natural-state resource

such as real estate, grasses and forests, and metals and minerals

Who is an Entrepreneur?Who is an Entrepreneur?Who is an Entrepreneur?Who is an Entrepreneur?

A person who alone assumes the risks and uncertainties of a business

He is also the person who takes the initiative and comes up with the essential idea of the business.

What is Production What is Production Possibilities?Possibilities?What is Production What is Production Possibilities?Possibilities?

In order to understand what is meant by PPF, we would first consider a hypothetical economy.

Production Possibilities Frontier

Robinson Crusoe’s Production Possibilities:Robinson Crusoe’s Production Possibilities:

ConsumptionGoods

Capital Goods

6 0

5 1

3 2

0 3

ConsumptionGoods

Capital Goods

6 0

5 1

3 2

0 3

Con

sum

ptio

n G

oods

Capital Goods

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Production Possibilities?Production Possibilities?Production Possibilities?Production Possibilities?

The combinations of goods that can be produced when resources and technology are used fully & efficiently

Con

sum

ptio

n G

oods

Capital Goods

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Production Possibilities CurveProduction Possibilities Curve

Capital Goods

Unattainable

Inefficient

Con

sum

er G

ood

s

1414

What is true along the What is true along the Production Production Possibilities Curve?Possibilities Curve? available resources are

used fully most efficient

combination of resources

What choices are made along What choices are made along the Production Possibilities the Production Possibilities curve?curve?

To have more of one product, units of the other product have to be given up

Opportunity Cost:Opportunity Cost:Opportunity Cost:Opportunity Cost:

The quantity of other goods that must be given up to obtain a good

Law of Increasing Law of Increasing Costs:Costs:Law of Increasing Law of Increasing Costs:Costs:

The opportunity cost of producing a good increases as more of the good is produced

Con

sum

ptio

n G

oods

Capital Goods

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

How do we have How do we have more of everything?more of everything?

By increasing our resources

Increased ResourcesIncreased Resources

Capital Goods

Con

sum

er G

ood

s

2121

What other ways can we What other ways can we increase our PPF?increase our PPF?What other ways can we What other ways can we increase our PPF?increase our PPF?

Innovations - an idea that takes the form of new applied technology

Technology - an improvement in capital

InnovationsInnovations

Capital Goods

Con

sum

er G

ood

s

2323

Con

sum

ptio

n G

oods

Capital Goods

0 1 2 3 4 5 6 7 8

9

1

2

345

67

8

0 1 2 3 4 5 6 7 8

9

1

2345

78

6

Once Rich it is Easier to Get RicherOnce Rich it is Easier to Get Richer

Once Poor it is Easy to Stay PoorOnce Poor it is Easy to Stay Poor

Rich Country Poor Country

Con

sum

ptio

n G

oods

Capital Goods

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

The Indestructible Nature of IdeasThe Indestructible Nature of Ideas

Does division of labor increase Does division of labor increase productivity?productivity?Does division of labor increase Does division of labor increase productivity?productivity?

Yes. People become more proficient in one activity which results in greater output per person

Specialization of labor :Specialization of labor :Specialization of labor :Specialization of labor :

The division of labor into specialized activities.

Adam Smith: Adam Smith:

“One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations, to put it on is a peculiar business, ...........”

The reason for such division of labor, he noted, is that these 10 people could make as many as 48,000 pins in a day. If they had each worked separately and independently, they could not have produced more than 200.

Production ofFish

Production ofShirts

Crusoe Island 2 8

YakamayaIsland

8 2

Production of Fish & Shirts per 8-hour DayProduction of Fish & Shirts per 8-hour Day

Example 1:

Absolute Advantage:Absolute Advantage:Absolute Advantage:Absolute Advantage: A country’s ability to produce a good

using fewer resources than the country with which it trades

The Theory of Absolute Advantage states that a country should completely specialize and produce the good in which it has absolute advantage.

Production ofFish

Production ofShirts

Crusoe Island 8 8

YakamayaIsland

8 2

Production of Fish & Shirts per 8-hour DayProduction of Fish & Shirts per 8-hour Day

Example 2:

In Crusoe Island, 1 Fish = 1 Shirt

In Yakamaya, 1 Fish = 2/8 = 1/4 Shirt & 1 Shirt = 4 Fish

& 1 Shirt = 1 Fish

1 S 1 F

4 F1/4 S

International Exchange Rate, 1 Shirt = 2 Fish

Comparative Advantage:Comparative Advantage:Comparative Advantage:Comparative Advantage: A country’s ability to produce a

good at a lower opportunity cost than the country with which it trades

The Theory of Comparative Advantage states that a country should completely specialize and produce the good in which it has comparative advantage.

What should a country What should a country specialize in producing?specialize in producing?What should a country What should a country specialize in producing?specialize in producing?

In those goods and services in which it has a comparative advantage

Should a country produce Should a country produce that with which it has an that with which it has an Absolute Advantage?Absolute Advantage?

Should a country produce Should a country produce that with which it has an that with which it has an Absolute Advantage?Absolute Advantage?

No! Not unless it also has a comparative advantage in those goods and services

Why?Why?Why?Why?

Because by so doing its opportunity costs may be too high

Production ofFish

Production ofShirts

Crusoe Island 10 4

YakamayaIsland

8 2

Production of Fish & Shirts per 8-hour DayProduction of Fish & Shirts per 8-hour Day

Example 3:

In Crusoe Island, 1 Fish = .4 Shirt

In Yakamaya, 1 Fish = 2/8 = 1/4 Shirt & 1 Shirt = 4 Fish

& 1 Shirt = 2.5 Fish

.4 S 2.5 F

4 F.25 S

International Exchange Rate, 1 Shirt = 3 Fish